How to Avoid IRS Audit: Watch Out for IRS Audit Red Flags (2024)

How to Avoid an IRS Audit: Watch Out for Audit Red Flags on Your Tax Return

The word audit can strike fear into the heart of any taxpayer. An audit can be a grueling and extensive process if you have well-organized records, but it can be an absolute nightmare if you have disorganized records and inaccuracies on your tax return. To help you out, this guide explains how to avoid an IRS audit, how the IRS selects accounts for audits, and audit red flags.

Want tax advice about IRS audits right now? Then, contact us at the W Tax Group today. We can talk with you about your situation, walk you through what happens during a tax audit, and help you decide the next path forward.

How the IRS Chooses Which Tax Returns to Audit

The Internal Revenue Service selects some tax returns for audits randomly. Other returns are identified by computers. An IRS tax audit is generally triggered by the agency’s computer center. The IRS runs returns through its Discriminant Function program called “DIF” or its Unreported Income Discriminate Index Formula (UIDIF) program. These programs identify returns for review by separating the taxpayers that are worth pursuing for more taxes and those that are not based on DIF and other scoring metrics.

About 2% of the selected returns are reviewed by humans, and about 1% are audited. Then, the IRS may start a correspondence audit to check on one or two small details through the mail. Or the agency may contact you and start a full-fledged audit that involves conversations with auditors and potentially in-person visits to your location. No one understands exactly how these programs work, but in the following sections, we will describe some red flags to watch out for.

Are Audits Random?

Some audits are random, and some returns are chosen for an audit because they have red flags identified by computer programs. There is no way to tell if you’re going to be audited until the IRS selects your return and contacts you.

What Is My Likelihood of Getting Audited by the IRS?

Your likelihood of getting audited by the IRS varies based on your income and the tax credits you claim. You’re most likely to get audited if you earn over $1 million per year or if you report no income. People who claim the Earned Income Tax Credit EITC) also face a heightened risk of audit. However, even if you file a regular income tax return with no red flags, you can still get audited. It boils down to chance.

In 2019, the IRS audited 0.8% of returns that claimed the EITC. This is a small number, but it’s more than double the audit risk for any income category below the million-dollar mark. Otherwise, the audit rates were as follows based on income ranges:

• No positive income 1.1%
• $1 to $25,000 0.4%
• $25,000 to $50,000 0.2%
• $50,000 to $75,000 0.2%
• $75,000 to $100,000 0.2%
• $100,000 to $200,000 0.2%
• $200,000 to $500,000 0.2%
• $500,000 to $1 million 0.6%
• $1 million to $5 million 1.3%
• $5 million to $10 million 2.0%
• Over $10 million 8.7%

These numbers are subject to change. For instance, a decade earlier, the IRS audited 1.8% of returns with the Earned Income Tax Credit. That’s double the current rate. The agency also audited returns at the following rates for different income levels:

• No positive income 20.6%
• $1 to $25,000 1%
• $25,000 to $50,000 0.6%
• $50,000 to $75,000 0.7%
• $75,000 to $100,000 0.7%
• $100,000 to $200,000 0.8%
• $200,000 to $500,000 2.3%
• $500,000 to $1 million 3.6%
• $1 million to $5 million 8.2%
• $5 million to $10 million 13.5%
• Over $10 million 21.5%

As you can see, the risk of an audit was a lot higher a decade ago than it is now. For instance, in 2010, one out of every five taxpayers with no income was audited, but in 2019, only one out of every 100 people with no income was audited. It’s important to note that audits were relatively low in 2019 because the IRS was working remotely for much of 2020 and 2021 due to COVID.

Are Audits Becoming a Bigger Risk?

In 2022, the Inflation Reduction Act approved $80 billion in IRS funding over the next 10 years. This is on top of the about $12 billion that the IRS already received every year. A significant portion of these funds will be used for IRS audits and collection enforcement actions. In early 2022, IRS staff levels were about the same as they were in the 1970s, but the agency plans to double its number of employees with the new funding. More hands on deck mean a heightened risk of audits.

How Long Does the IRS Have to Audit My Return?

Under the tax laws, the IRS typically cannot audit a return more than 3 years old from the filing date. However, if the IRS starts to audit your last three returns and sees substantial mistakes, it can go back up to six years. If you committed tax fraud, there is no statute of limitations. The IRS can go back indefinitely. Once a tax has been assessed after an audit, the IRS has a 10-years statute of limitations on collections.

Will Amending a Return Cause an Audit?

Amending a return doesn’t instantly trigger an audit, and it doesn’t increase the risk of your first return getting audited. However, when you send in an amended return, the IRS usually looks a closer look at it. To be on the safe side, you should make sure that your amended returns are completely accurate.

How to Avoid an IRS Audit

There is no guaranteed way to avoid an IRS audit but there are things you can do to lower your probability of being audited. Check out these tips to reduce your likelihood of being audited.

Check Your Tax Deductions – This means more than making sure your math adds up. A return with a few math errors usually doesn’t trigger an audit especially if you used a tax filing program like Turbotax. Instead, the IRS looks for signs that you have claimed too many deductions.

Don’t claim excessive deductions. For instance, don’t take large deductions on medical expenses unless you can back them up with proof — only expenses over 7.5% of adjusted gross income are deductible. Similarly, don’t inflate charitable donations unless you really made the donations. The IRS’s programs will compare your deductions to taxpayers or businesses in your income bracket based on your location, family size, and profession. If the agency’s computers spot big differences, they may select you for an audit.

Lastly, make sure that all of your itemized or business deductions make sense. For example, writing off a horse as a business expense doesn’t make sense if you run a deli. Claiming moving expenses doesn’t make sense if your address is the same as last year.

Check Your Income to Expenses Percentage – When reviewing deductions, the IRS is looking for individuals with high expenses and low income which are inconsistent with the averages in your category. This applies to both itemized deductions on your Schedule A and business deductions on your Schedule C or other business return.

Some notable experts such as Amir Aczel will argue that itemized deductions should rarely be more than 35% of adjusted gross income on Schedule A and up to 52% of revenue with a Schedule C (filled out by businesses). To calculate your percentage, divide your business deductions by your business revenue, or divide your itemized expenses by your pre-tax income.

If your ratio exceeds these numbers, be aware that may be a red audit flag to the IRS. However, sometimes, your numbers will honestly exceed these ratios. If you’re truthful and using your actual expenses, that is fine. Just make sure you have supporting documentation.

Report All Income – You must report income correctly if you want to avoid an audit. This includes all bank interest, capital gains on stocks, real estate, gambling winnings, and any other potential income sources (even foreign accounts). Realize that the IRS receives W2s and 1099s from your employer and other payers, and those need to match up with what you are reporting as income. The IRS runs all of these elements through its matching computers, and errors increase the risk of an audit.

Include All Necessary Schedules and Fully Complete Your Tax Return – If you failed to fully complete your tax return or failed to include necessary schedules this may trigger an IRS audit. To be on the safe side, you may want to work with a tax professional. They can help to ensure that you don’t miss anything when you file your tax return.

Some tax pros offer audit protection. Then, if you’re selected for an audit, they help you through the process. In all cases, you probably shouldn’t navigate an audit by yourself. You should contact a professional to help you.

File A Tax Return – If you didn’t file a tax return, it doesn’t mean you can’t be audited. In fact, the IRS may file a “Substitute of Return,” on your behalf. This is generally not good because credits and deductions are kept to a minimum, increasing your tax liability. Then, the agency can audit the return they filed for you.

Avoid Rounded Numbers – Rounded numbers are unrealistic, and usually will cause the IRS programs to select your tax return for a review. For instance, if all of your business deductions are even multiples of $100, that may be a red flag to the IRS. Or if all your deductions end with a 5, that can be a sign that the numbers aren’t real.

Don’t wing your tax return, the IRS and state taxes are not a joke and should not be underestimated ever. Always, make sure you report accurate information.

Avoid Running Into The Law – Don’t break the law, because if you are arrested for drug possession/intent to sell, or some other illegal activity this could trigger a review of your tax returns.

Avoid Claiming False Dependents – If you are divorced or share a child with an ex, you should realize that only one parent can claim any child as a dependent. Make sure that your ex-spouse is not claiming your child as a dependent if you plan to claim them. Also, make sure that you understand the rules for which dependents you can claim and how that affects various credits.

For instance, you generally cannot claim your boyfriend or girlfriend’s child as a dependent for the purposes of the EITC. Even if you have the parent’s permission and you take care of the child, this is still not allowed. Try to avoid mistakes like this, and make sure that you never make up a dependent for a false claim.

By following the above tips, you can reduce your risk of facing a potential audit. It’s also important to try to avoid the red flags outlined in the next section

IRS Audit Red Flags

There are several red flags that make your return more likely to be audited. Again, you can never tell for sure if you will be audited, but you need to be aware of the potential issues that might draw the IRS’s attention to your return. Basically, if your return shows significant tax advantages compared to other returns reflecting similar situations, that is a red flag.

1. Cash-Based Income Professions: If you are in a certain profession like being a waiter, a hair stylist, a deli owner, or any profession where income is largely based on cash transactions, your IRS audit chances are much greater. Unfortunately, there’s not much you can do if you’re in one of these industries. Just file your return correctly, make sure you report all your cash transactions, and keep your records well organized in case you’re selected for an audit.
2. Self-Employment – If you are self-employed, you are much more likely to be audited because the IRS knows that many individuals will claim business expenses that should be personal expenses. The IRS looks for schedule c audit triggers such as excessive business travel expenses, high entertainment costs, or a large home office deduction. Again, this doesn’t mean you shouldn’t claim legitimate expenses such as the home office deduction. Just be prepared to back up your claims with records. For instance, to qualify for the home office deduction, part of your home needs to be used exclusively for work. You may need to prove this if you are audited.
3. If You Make More Than $1 Million a Year – Statistics show that your risk of audit increases when you earn millions of dollars per year. It gets the worst when your income tops $10 million. Does this mean that you should give up your career and go be a barista? No. Should you take a few more days off? Maybe. Ultimately, if you’re earning at this level, you should be extremely diligent about ensuring that your tax return is correct because your audit risk is high, and it’s likely to get higher in the next few years.
4. Businesses That Report Small Losses – Businesses that report losses are typically targets for the IRS because an audit has a greater potential of producing income if incorrect. Basically, if the IRS looks at your return and thinks that you should have paid more in tax, it may follow up to try to get its money.
5. Overly Similar Numbers — If the IRS sees the same numbers over and over again on your return, that can be an audit red flag. This is another Schedule C trigger. For instance, if all of your expenses end in double 0’s or if you end everything with “7” or any other digit, you may have some trouble.
6. Using an Unscrupulous Tax Preparer — The IRS tracks the audit results for tax preparers. Anyone who prepares tax returns for pay gets a unique ID number to make this possible. If the IRS selects a return for an audit and then realizes that the tax preparer was dishonest, the agency may start looking at the tax preparer’s other clients. In contrast, if a tax preparer has gone through several no-change audits or audits with immaterial changes, the IRS is going to look at the returns they have submitted in a more positive light.
7. A Large Tax Refund — A large tax refund can also be a red flag. That is why so many returns with no income reported on them get audited. Generally, when someone submits a return with no income, it’s because they’re trying to get tax credits or establish net operating losses that they can roll to other years. Again, if this is legitimate, it’s fine, but you need to be aware that it may bring additional attention to your return.
8. Foreign Assets or Foreign Bank Accounts — Foreign assets and accounts can also make the IRS a little nervous, but that doesn’t mean that you should hide them from your return. In fact, you must report these elements if required. If not, you can face significant penalties. Cross-border transactions can also be a red flag for audits.
9. Excessive Charitable Contributions — This is an abused deduction so the IRS tends to look closely at returns that have an excessive amount of deductions. In particular, if you make a non-cash donation, make sure to attach the required form if you want to avoid suspicion.

In summary, these are just a few things to consider when trying to reduce your probability of being audited. Realize that there is no surefire way to avoid an IRS audit. There are only things you can do to lessen your chances of an audit. If you are faced with an IRS tax audit or need representation, fill out the form on the right for a free quote or give us a call today for a free consultation.

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